CHAPTER 9 LongTerm Financial Planning

1
CHAPTER 9Long-Term Financial Planning

• Plans strategic, operating, and financial
• Sales forecasts
• Constant ratio method
• AFN formula method

2
Why is a good sales forecast essential to a good
financial forecast?

• If sales forecast is too low
• Insufficient assets to meet demand.
• Orders back up, delivery times lengthen, goodwill
  lost.
• If sales forecast is too high
• Excess capacity will result.
• Write-offs for obsolete inventory and equipment.
  Excess costs.

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Steps for making a sales forecast

• Obtain historical sales trend.
• Analyze historical economic factors and business
  activity of customers.
• Consider effect of new products.
• Consider competitors actions.
• Consider effects of advertising campaigns,
  promotional discounts, credit policy changes, etc.

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Assumptions for 1996 pro forma income statement,
g 20

• Forecasted sales 1995 sales (1g).
• COGS and Admin. Exp. are expected to remain at
  their current of sales.
• Interest and dividend payments will be a function
  of financing require-ments. As a first
  approximation, they are held at 1995 levels.

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Pro Forma Income Statement
1995 1996 (1995 x 1.2) Sales 7,500
9,000 COGS 6,000 7,200 Admin. Exp.
780 936 EBIT 720 864 Interest
Expense 120 120 EBT 600
744 Taxes (40) 240 298 Net Income
360 446 Dividends 108 108 Add.
to R.E. 252 338 Hold constant in
first approximation.
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Dividends and Retained Earnings

• Net Income 360 446
• Dividends 108 108
• Add. to
• Ret. Earnings 252 338

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Assumptions for 1996 pro forma balance sheet.

• Operating at full capacity, so all assets
  increase at same rate as sales.
• Increase liabilities that increase spon-taneously
  with sales by the projected sales increase . For
  other accounts, prior years figures are carried
  over.
• 1996 RE 1995 RE 1996 NI -1996 Div.
• AFN Pro forma total assets - pro
  forma total claims.

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Projected Assets
1995 1996 Actual 1st Approx. (1)
(Col. 1 x 1.2) Cash 300
360 Receivables 500 600 Inventory
1,000 1,200 Current Assets 1,800 2,160 Net
fixed assets 4,000 4,800 Total
assets 5,800 6,960 Operating at full
capacity, hence assets increase with sales.
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Projected claims
1995 1996 Actual 1st Approx. (1)
(Col. 1 x 1.2) Accounts Payable 200
240 Receivables 100 120 Notes
payable 250 250 Current liabilities
550 610 Long term debt 2,400
2,400 Total debt 2,940 3,010 Common stock
2,000 2,000 Retained earnings 850
1,188 Total claims 5,800 6,198 Held
constant AFN Projected Assets - Projected
Claims 6,960 - 6,198 762.
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Additional Funds Needed

• Projected Assets minus projected liabilities
  Additional Funds Needed (AFN)

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Calculation of AFN

• Total projected assets needed to support
  projected operations with 20 incr. in sales
  6,960,000
• Without added financing, projected liabilities
  are6,198,000
• Total Shortfall 762,000

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What assumptions underlie the constant ratio
method?

• Assets are being used to capacity.
• There are no economies or diseconomies of scale,
  so balance sheet items will change in direct
  proportion to sales.
• The profit margin will remain constant.

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Additional Data

• Target capital structure
• 50 debt (10 ST, 40 LT)
• 50 common equity (includes common stock, paid
  in capital, retained earnings)
• Additional funds will be raised as
• 10 notes payable,
• 40 LT debt,
• 50 common stock

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What dollar amounts of each type of capital must
we raise to cover the firms cash shortfall?

• of each type
• 762,000 x of type

10 40 50 100
Notes payable LT debt Equity
76,200 304,800 381,000 762,000
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Incorporating additional financing costs

• Assume
• Firm raises the 762,000 in the 10/40/50
  proportions.
• Cost of S-T debt 12
• Cost of L-T debt 10
• Pnet 10/share
• 100,000 shares outstanding

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What effect will the additional financing have on
the pro forma income statement?
S-T interest 0.12(76,000) 9,144 L-T
interest 0.10(305,000) 30,480 Total
additional interest 39,624
17
Additional Equity Costs
18
Pro Forma Effects Income Statement

• New interest expense
• 120,000 39,624 159,620
• New dividend expense
• 108,000 41,148 149,148
• New addition to RE 273.5

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Pro forma with financing feedback
w/o feedback w/feedback Sales 9,000 9,000 C
OGS 7,200 7,200 Admin. Exp. 936
936 EBIT 864 864 Interest Expense
120 159.6 EBT 744 704.4 Taxes
(40) 298 281.8 Net Income 446
422.6 Dividends 108 149.1 Addition to
RE 338 273.5
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Pro forma balance sheet with financing feedback

• w/o feedback w/feedback
• Cash 360 360
• Receivables 600 600
• Inventory 1,200 1,200
• Current Assets 2,160 2,160
• Net fixed assets 4,800 4,800
• Total assets 6,960 6,960
• Asset requirements dont change.

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Pro forma balance sheet (cont.)

• w/o feedback w/feedback
• Accounts Payable 240 240
• Receivables 120 120
• Notes payable 250 326.2
• Current liabilities 610 686.2
• Long term debt 2,400 2,704.8
• Total debt 3,010 3,391
• Common stock 2,000 2,381
• Retained earnings 1,188 1,123.5
• Total claims 6,198 6,895.5
• AFN this pass 762 64.5
• Cumulative AFN 762 826.5

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Pro Forma Effects Balance Sheet
increase by increase by increase by
76,000 305,000 381,000 762,000
Notes payable LT debt Common stock
Total new financing
However, note that addition to retained earnings
declined by 64,000 due to the additional
dividends payable.
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• We could go through another adjustment to finance
  the 2nd pass 64.5 AFN. This would lead to a
  very small 3rd pass AFN, and would alter slightly
  the liability accounts.
• Given forecast errors, probably not worthwhile.

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Some pro forma ratios

• Current ratio 2,160/686.2 3.15x
• ROE 422.6/(2,3811,123.5) 12.1
• TIE 864/159.6 5.4x
• Management would decide if these ratios, hence
  the overall forecast, look OK, or if the plan
  should be revised.

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Assume the 1995 profit margin and dividend payout
will be maintained. Use the AFN formula to
determine the 1996 AFN.

• AFN (A/S)?S - (L/S) ?S - MS1 (1-d)
• (5,800/7,500)(1,500)
• - (300/7,500)(1,500)
• - (360/7,500)(9,000)(1-.3)
• 1,160 - 60 - 302.4
• 797,600 vs. 826,500

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Why is the AFN that results from the equation
different from the AFN from the pro forma
financial statements?

• AFN formula assumes constant profit margin and
  payout ratios. Pro forma method allows these
  ratios to vary depending on financing decisions.
• AFN formula does not take into account financing
  feedback.

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How do (1) dividend policy, (2) profitability,
and (3) capital intensity (A/S) affect the AFN?

• Higher payout higher AFN
• Higher profit margin lower AFN
• Highercapital intensity higher AFN

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What is the sustainable growth rate and how is
it affected by PM, payout, and capital intensity?

• Sustainable growth that growth which can be
  financed without having to use external capital.
• Sustainable growth
• rises with PM
• falls with payout
• falls with capital intensity

29
If the firm operated its fixed assets at only 80
of capacity in 1995, what would its 1996 AFN have
been?

• Capacity Current sales 7,500
• sales of capacity 0.8
• 9,375
• With 1995 fixed assets, sales could have been as
  high as 9,375.

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• The 4,000 of 1995 fixed assets would support
  sales of 9,375. Since 1995 sales were projected
  at only 9,000, there would be no need for any
  additional fixed assets.
• The original AFN of 762,000 included 800,000 of
  fixed assets. Therefore, the new AFN would be
  762 - 800 -38 (a surplus).

31
List three conditions that could invalidate
forecasts based on constant ratio methods.

• Economies of scale
• Excess capacity
• Lumpy assets

32
Other forecasting methods that could be used to
project financial statements

• 1. Regression (simple or multiple).
• . Generally, the kind of forecasts done in this
  chapter are used as a starting point and are
  modified using the method above.